In SEC vs. Goldman, Who's Really at Fault?

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Let's stipulate that there's a problem with the power of Goldman Sachs. The firm takes vast risks and earns vast profits; then, when it gets into trouble, as it did after the Lehman Brothers failure, it turns to the government for a bailout. But the case the Securities and Exchange Commission has brought against Goldman also involves a problem. Unless the SEC is sitting on more evidence than it has laid out so far, the charge sheet looks flimsy. If Goldman has become a poster child for excessive power on Wall Street, the SEC might become a poster child for government power run amok.

The SEC's 22-page complaint states that Goldman sold fancy mortgage securities without disclosing that a hedge fund manager, John Paulson, was betting that those same securities would go bad. This is a non-scandal. The securities in question, so-called synthetic collateralized debt obligations, cannot exist unless somebody is betting that they will lose value. The firms that bought Goldman's securities knew perfectly well that some other investor must be taking the opposite position. It was their job to evaluate the Goldman offer and make up their own minds. One of the big losers in the deal was IKB, a German bank with a big business in mortgages. We're not talking mom and pop.

Perhaps the SEC is suggesting that Paulson's involvement changes this logic, because the hedge fund manager is famous for making billions from his mortgage bets? There's a superficial case here: Even if investors don't mind that somebody else is on the other side of the trade, maybe they wouldn't want to bet against a superstar. But at the time of the deal, Paulson was a low-profile player whose name would not have set off alarm bells. And intermediaries like Goldman are not supposed to blab about the identities of their clients.

Next, the SEC complains that Paulson had a hand in designing the securities, maximizing the chances that they would blow up. He did the equivalent of building a timber house with a large fireplace and a blocked chimney, then buying fire insurance on the structure. Shocking though this may sound, it is another non-scandal. An investor who wants to bet against a bundle of mortgages is entitled to suggest what should go into the bundle. The buyer is equally entitled to make counter-suggestions. As the SEC's complaint states clearly, the lead buyer in this deal, a boutique called ACA that specialized in mortgage securities, did precisely that.

Finally, the SEC asserts that Goldman, and specifically its young mortgage whiz, Fabrice "Fab" Tourre, tricked ACA into believing that Paulson meant to bet on the mortgages' soundness, not the other way around. This is the nub of the case, and if there's proof that Goldman or Tourre was dishonest, the SEC could yet emerge with its reputation intact. But none of the e-mail fragments quoted in the complaint comes close to being a smoking gun.

What the complaint does show is that ACA believed Paulson was a buyer, not a seller; and the really intriguing mystery is how ACA could have been so dumb. As the deal was taking shape, ACA and Paulson met repeatedly. If ACA had any doubt as to Paulson's intentions, surely it could have asked him a straight question rather than relying on alleged hints from Goldman. Throughout the negotiations, Paulson kept proposing notoriously low-quality mortgages for the bundle and vetoing high-quality ones. It should have been obvious to ACA that he meant to bet that they would go down.

The worst that can be said on the basis of the available evidence is that Goldman knew ACA was being stupid and failed to point this out. That falls far short of the offenses that the SEC alleges, which might be why two of the SEC's five commissioners refused to vote for the action against Goldman -- a rare split in an enforcement case. And yet, rather than treat the SEC's adventure with due caution, politicians and regulators are jumping on the bandwagon. British Prime Minister Gordon Brown, who just happens to be fighting an election campaign, has pushed British regulators to pile on to the SEC case. German Chancellor Angela Merkel, who could use some market scapegoats to distract from the euro zone's debt crisis, is threatening to follow suit. Congressional investigators are planning to grill Goldman officials for the umpteenth time.

Much is wrong on Wall Street, and Congress should pass some version of the regulatory package that is bottled up in the Senate. But the premise for more regulation is that the regulators will behave responsibly. Let's hope the SEC remembers that.

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